Corruption Scandal Makes the Brazilian Elections Even More Exciting

(from my colleague Ilan Solot) 

The political outlook for the Brazilian elections is being rocked by leaked information about the corruption scandal surrounding Petrobras’ former director Paulo Roberto Costa – affectionately known as the “suicide bomber.”
The man-bomb has agreed to a plea bargain (i.e. providing information in exchange for a reduced sentence) and has begun to talk. According to the leak in the “Veja” magazine, he has essentially confirmed that the multi-billion dollar deal was designed to keep congressional support for President Dilma’s ruling coalition (and Lula’s coalition before her). He cited dozens of politicians involved, including several member of the PT such as the party’s Treasurer, a minister, and a former minister. Eduardo Campos, the former presidential candidate killed in the airplane crash, was also cited. Here is our first take on the developments.
What does this mean to the race?
– This is likely to be more noise than signal in the end. But whatever impact there is, it will be disproportionately negative for President Dilma.
– The impact on voting patterns will probably be small and unlikely to change the first round result. Dilma and Marina will still probably face each other in the second round because:
– Past political scandals have not impacted the president as much;
–  Dilma’s support rests largely on lower-income groups, which will probably see less of the media coverage and be less sensitive to it;
–  Dilma is not too far from her very elevated hard-core support base (i.e. floor), which are voters who will not change their vote no matter what happens.
But it does represent a large tail risk for Dilma and the PT (see below).
– This could hurt Marina, since Campos was implicated. However, it will be difficult for Dilma to exploit this given her own party’s involvement.
– From another perspective, another high-profile corruption case could increase the public’s rejection of the political system and status quo, further fuelling the protest vote that has benefited Marina so much.
Unless Aecio (PSDB) feels that now he has a real shot at winning, which we very much doubt, he is likely to focus his attacks on Dilma, whilst sparing Marina. Aecio could also benefit from the scandal by having the moral high ground, since the PSDB has so far not been implicated.
This increases the chances of an alliance between the Marina’s PSB and the PSDB. For two reasons: (1) Because the PMDB, another coalition option for a Marina government, is likely to be severely hurt by scandal, it will make it difficult for Marina’s new-politics government to make an alliance with the party so heavily involved in the corruption allegations. (2) Marina may come out a bit bruised and, if anything, Aecio’s “value” will rise.
The tail risks and the low probability events:
(A) Aecio comes back. The PSDB has not been implicated at all in the scandal, as far as we know. If Campos’ involvement in the scandal contaminates Marina, she could lose her status as a clean representative of new politics. This could give Aecio the moral high ground to go heavily on the offensive against both Marina and DIlma, aiming for the second round. The bar is high for Aecio to go down this path, probably requiring a substantial change in polls in his favor. The strategic risk in this gambit is that it will greatly reduce his changes of an alliance with Marina later on, which will probably be necessary for him to beat Dilma in the second round in any reasonable scenario.
(B) Increases the chances of a first round alliance between Marina and Aecio. This is how the narrative would go. Dilma gets damaged enough by this scandal to make a first round victory by Marina possible. In this case, Aecio and Marina could cut a deal: he supports her in to win a first round victory and Marina supports him in the next elections (Marina has stated she will only stay in the presidency for one term). Then Aecio would focus his efforts on trying to rescue his home state of Minas, the second largest in the country, and where PSDB has lost a lot of ground. This scenario is still very unlikely, but the odds have increased.
(C) The scandal reaches huge proportions and compromises the existence of the PT and Lula’s political future.This story has the potential to not only eliminate Dilma, but also undermines the PT in local elections – though recent history of scandals suggests otherwise. In any case, if Lula is as close to the bomb-man as some reports suggest, this could represent a dramatic change in outlook for Brazil’s future. Most observers consider it almost a given that Lula will run in the next presidential elections, so this could jeopardize or weaken his bid. Separately, Marina already hinted at the idea of picking off political leaders she respects from other parties, opposition or not, including the PT. Recall that Marina was a member of the PT for decades. Maybe a combination of a resounding Marina victory, with yet another political scandal at the core of the PT, and the loss of the Lula “anchor” will result on a mass exodus from the party. This would mean a complete re-thinking of Brazil’s political dynamics.
Market implications: short-term mild positive, but big potential long-term positive. In the short term, markets will be also trading the Sensus Poll published over the weekend as a positive, pro-Marina event. It showed a first round tie between Marina and Dilma, and Marina with a 47.6% support in the second round, compared with Dilma’s 32.8%. But the new Petrobras scandal variable will somewhat dampen the importance of these polls. Longer term, markets will take any developments that will weaken the PT as a positive for asset.

This piece is cross-posted from Marc to Market with permission.